How many credit cards have you maxed out? If the answer is more than 1, then you are not alone. Many people in this country are in a similar situation, relying on credit cards to make ends meet. Unfortunately, it seems that products and services keep getting more expensive.
If you follow reports on the macro economic data, you can see that inflation has been historically low over the last 6 or 7 years. According to the US Inflation Calculator, the rate of inflation has remained below 2% for 6 out of the last 8 years even though the target is about 3%. But why does it still feel like things are so expensive? Do you feel like your finances are running thin?
If so, there is a reason!! The Answer? INCOME!
Inflation adjusted Income has been declining since 2000-2002, and this is what is making so many Americans feel like they are constantly strapped for cash.
The two charts to the left show income growth since 1967. The 1st chart portrays growth in nominal dollars and shows a gradual incline. On the other hand, the second chart is inflation adjusted, and here you can see that all Quintiles (divided into 5 groups), including the “Top Quintile” for the top 20%, show declining income starting in the 2000-2002 time frame.
The average middle class American is represented in the second Quintile (up to 83k) and the Middle Quintile (up to 52k).
With real income essentially decreasing while expenses continue to rise, it’s easy to decipher why many Americans are simply getting by. And it’s easy to see why so many Americans may have some credit cards that are maxed.
Well, what can you do about it? One thing that I have been able to do is help clients put together a strategic plan that equips them to attack these credit card balances.
While every individual situation is inevitably going to be different, there are some common themes among all that should be noted. Also, it is important to understand the credit card owner’s actual purpose for fixing their particular situation. For instance, someone who is trying to build their credit score up to qualify for a car loan or home so that they can get a better rate will have a different outlook than someone who just wants to eliminate their debt in the most efficient way possible.
2 Rules of Thumb:
(However, it’s crucially important to understand the big picture before blindly implementing)
1) Pay down the highest rate card first, then attack the card with the next highest rate
2) Pay off the smallest balance first, then attack the next smallest balance card with the money that you had been paying on the first one.
And so on….
Let’s look at two separate examples.
Example 1) Pay Down Balances Strategically:
Let’s say Roger just moved into an apartment and signed a 2-year lease. He has been at his new job for about 6 months, but before that he was unemployed for about 3 months. As a consequence, he built up $12,000 in credit balances spread across 4 credit cards. His main goal right now is to pay down all of his credit card bills.
While organizing his budget, Roger determines that on average he has about $400 extra each month to apply towards paying down his credit card balances. He also realizes that his credit score has dropped into the low 600’s because his Discover Card includes his credit score on the statement…
When Roger seeks my advice, I advise him to access his credit report info through Annualcreditreport.com for free. From analyzing the info, my best guess is that 3 of his 4 credit card balances are right near the limit.
But again, we must consider the individual’s outlook. Roger’s main goal is to most efficiently pay down the balances; he is not so much worried about credit scores at this time. So my best recommendation is to take the extra $400 he has available after all of his minimum payments are met and apply that toward the credit with the highest interest rate.
After launching the excess cash towards the highest interest rate credit card, the next goal would be to take the minimum payment that was being paid on that card, plus the $400 and put that sum towards the next highest interest rate card. This process would repeat until all the balances are paid off.
Example 2) Build Credit Scores Quickly for Home Purchase:
In this second example, we have a slightly more complex situation. Rachel is looking to purchase a home in 6 months. She has a stable job and has already set aside her down payment funds. Her main goal right now is to build her credit score from the 640’s up to the 720’s so that she has the opportunity to get the best mortgage interest rate possible.
She has multiple credit card balances that she accumulated while starting her side business. The business has been finding success, so she now has some extra cash flow to start applying toward the credit cards. She estimates that she would have about $500 extra that she could apply toward the balances.
Because it can take some time for changes to have an impact on credit score, it is important for Rachel to plan out how best to utilize the funds in order to build her score.
She has 5 credit cards with all of the balances totaling $19,000. Here is a quick list of the balances, credit limit, and rate included:
In this situation, there is not one right answer; there are multiple methods that would work.
But this is what we did.
1) We took the first set of $500 and paid $300 toward Card 5, and took the remaining $200 and applied toward Card 4. The rationale was that one of the major elements that factor into the credit bureau algorithms is Credit Card Utilization, which is the balance used as a percentage of the total credit limit. We were able to make the most impact right away by taking Card 5 from 100% utilization down to 40% utilization by paying it down to $200. Then, by paying Card 4 down an extra $200, we were able to drop from 80% utilization down to 60% right away.
This is how the balances looked after month 1:
2) The second month, we took the $500 and applied $100 of it toward Card 4 to decrease the balance to $100 and reduce the utilization ratio to 20%. Then we took $300 and applied toward Card 4 in order to bring the balance down to $300 and the ratio to 30%. Finally, we applied the remaining $100 to Card 3.
This is how the balances looked after month 2:
3) For the third month, we applied the full $500 toward Card 3. Cards 4 & 5 were in a healthy utilization ratio position, so we wanted to progress with the plan of making the most impact. In this case, it’s with Card 3. This brings the balance down to $2,200, plus a utilization ratio of 74%-much healthier than the 90%. Along the way, Rachel was receiving updates on her score through her Discover card and she noticed that there was already a shift up in her score.
This is how the balances looked after month 3:
4) For the fourth month, we applied the full $500 toward Card 3, bringing it down to $1700 with a utilization ratio of 57%.
5) During the fifth month, we applied the full $500 toward Card 2, bringing down to $4,401 with utilization ratio down to 88%.
6) In the sixth month, we applied the full $500 toward Card 2, decreasing its balance to $3,901 and dropping the utilization ratio down to 78%.
The final balances looked like this:
After executing this plan, we were pleasantly surprised with the results!!
The score catapulted to 702. We didn’t reach our goal of 720, but we still accomplished a tremendous amount.
If you have any questions or need advice, feel free to send your inquiry to:
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